Doesn't even know what he doesn't know

Running true to form, Al Gore has a column in today's WSJ pointing the way to earthly redemption. Mr. Gore does understand that there are such things as "externalities", but beyond that there are some flawed assumptions about how the world works. Pete Du Pont has a different take. Over at Econopundit, Steve Antler deals with the matter by showing more restraint than I would. He juxstaposes excerpts with his own comments.

Capitalism and sustainability are deeply and increasingly interrelated. After all, our economic activity is based on the use of natural and human resources. Not until we more broadly "price in" the external costs of investment decisions across all sectors will we have a sustainable economy and society.

The crux of the argument is right here. Capitalism can't bring you "sustainability" but heroic social engineers like Al Gore can. The problem is in that word "sustainability." It's religion.


Externalities are costs created by industry but paid for by society. For example, pollution is an externality which is sometimes taxed by government in order to make the entity responsible "internalize" the full costs of production. Over the past century, companies have been rewarded financially for maximizing externalities in order to minimize costs.

No, externalities are costs paid for by someone else -- not always by "society as a whole." Companies often shift costs onto other companies. The earliest examples using the Coase theorem had to do with upstream businesses issuing effluents which raised the costs of downstream water-using businesses.

Only the doctrinaire public service technocrat sees all costs of pollution borne by the "public" and all benefits borne by the business community. This is a kind of class analysis most modern economists no longer accept.

There's plenty more to see over at Econopundit. If Mr. Gore could set aside his beliefs long enough to study three books: The Fatal Conceit, The Bottomless Well and The Singularity is Near, he might relax. But it's not going to happen. As we go racing towards the singularity, more energy options will be available and sustainability will be a natural outgrowth of our freedom to innovate and adapt!

Work and Retirement

People are living longer. Life expectancy has been creeping up over the last couple of decades, but with upcoming technology, I'm confident that a life expectancy of 100 will be achieved in my children's lifetime (i.e. they'll likely live to 100).

On the other hand, people seem to be retiring earlier and earlier. Many of my cohorts are planning on retiring in their fifties. Others, who've had financial strains such as divorce or a failed company, are lamenting that they might, worst case, actually have to work into their 60s. On current trends, I can see the expected retirement age creeping down to 50.

On the third hand (I must be an octopus), we seem to be taking longer to enter the work force, mostly for good reason. It can take ten years or longer to get a Ph.D. in some fields. We seem to need ever more lawyers and managers with MBAs. Healthcare is becoming an ever larger percentage of our GDP and it takes forever to become a doctor. At the present rate, the average age of entering the work force might be as high as 25.

I've just painted a picture where, on average, people enter the work force at 25, leave at 50, and live to 100. This implies (making the somewhat erroneous assumption of a flat age distribution) that there will be one worker for every four people.

This scenario, regardless of how it is financed, is a far, far less well off scenario than one where 3 out of 4 people work, which would be the case if everybody in the picture above worked till they died. It doesn't matter if everyone saves huge percentages of their income in order to prepare for their retirement years. In that case, there would be a large number of dollars chasing the few goods and services that can be produced by the one out of four people working. It doesn't matter if the government somehow extracts huge taxes out of the workers to pay for the retirees (and children). The total pie to be consumed would be much smaller than it would be if we all work for a larger percentage of our lives.

Thus, when pundits pontificate about fixing social security and other retirement entitlements, I can't even start to take it seriously unless it provides an incentive for people to work longer. A society in which people are retired for 20 or 50 years of their adult life is a poor society complete with a great deal of intergenerational resentment. It's simply unworkable in my opinion. And that's without even taking into account that as I've been watching people retire, I've noticed that they seem to go down hill much faster after retirement. I think that retirement is unhealthy for most people.

That's why a new book (or more accurately the description of said new book since it hasn't been released yet) by Charles Murray, the at least partially evil genius (in my opinion) author of the Bell Curve, caught my eye. In "In Our Hands", Murray proposes tossing social security (and the other entitlement benefits such as medicare) out the window and replacing them with a $10,000 stipend to every adult over 21:

The one I have devised--I call it simply "the Plan" for want of a catchier label--makes a $10,000 annual grant to all American citizens who are not incarcerated, beginning at age 21, of which $3,000 a year must be used for health care. Everyone gets a monthly check, deposited electronically to a bank account. If we implemented the Plan tomorrow, it would cost about $355 billion more than the current system. The projected costs of the Plan cross the projected costs of the current system in 2011. By 2020, the Plan would cost about half a trillion dollars less per year than conservative projections of the cost of the current system. By 2028, that difference would be a trillion dollars per year.

Many questions must be asked of a system that substitutes a direct cash grant for the current welfare state. Work disincentives, the comparative risks of market-based solutions versus government guarantees, transition costs, tradeoffs in health coverage, implications for the tax system, and effects on people too young to qualify for the grant, all require attention in deciding whether the Plan is feasible and desirable. I think all of the questions have answers, but they are not one-liners; I lay them out in my book.

Assuming that the questions really do have answers that aren't too evil, the single solution that "the Plan" offers that I think is absolutely critical is that it eliminates the concept of a retirement age, or a specific point at which retirement benefits begin. It would enable people to decide when to retire based on the proposed stipend and its current value in the market.

This would provide an automatic feedback mechanism. If too many people decided to retire too early, the goods and services that $10,000 could buy would drop and this would encourage people to keep working. This self regulating mechanism would reduce the likelihood of situations where there are too many people who aren't working. In other words, it's a solution that could work for the long haul, and it can continuously adapt as technology and society changes.

Investment Surplus

The United States trade deficit is one of those statistics that economic doomsayers like to latch onto. When people start talking about the trade deficit, I often point out that a trade deficit is the same thing as an investment surplus. Usually people ignore my little quip. However, someone recently requested that I explain the term investment surplus to them. I've been patiently waiting for a clear and simple explanation to materialize in the blogosphere, but it's been a while, and I haven't found what I'm looking for. To be sure, I've seen many postings using and even defining investment surplus, but I've found them a little more complicated than what I want, so I've decided to roll my own explanation.

The starting point I've chosen is a simple transaction proposed by Don Boudreaux in a recent article:

My next-door neighbor in Virginia agrees to mow my lawn for $25. He mows and I immediately give him $25 in greenbacks. Rather than spend his earnings on beer or a back massage, my neighbor uses the $25 to by a share of Microsoft.

This transaction is the epitome of a positive economic transaction. There was a need and a service was provided by the neighbor (let's call him Joe) to meet that need. Trade and investment ensued. Great!

The only possible downside is that Don is $25 poorer. Indeed, you might ask why lazy ol' Don didn't mow his own damn lawn. For now, assume that as Chairman of the Department of Economics at George Mason University, Don is able to consult at $250 per hour, and assume that he consulted for the hour that he would have otherwise spent mowing the lawn. In this case, he too is better off and the entire transaction is nothing but positive (assuming his clients got their money's worth).

Note that it doesn't matter much if Joe buys a share of stock or loans money to a business (probably via depositing the money in a bank). He's providing capital for others to use and for that he will get a return on his investment.

So far, the entire transaction was within the United States. But now, let's assume Don lives in San Diego and his neighbor, Jose, lives in Tijuana, Mexico. Now, all of the sudden, this very positive transaction adds $25 to the trade deficit and $25 to the investment surplus of the United States. Notice that a trade deficit can only happen in conjunction with an investment surplus. If Jose, or whoever ultimately ends up with the 25 US dollars, spends them on an American product or service, there's no net trade deficit and no net investment surplus. You can't have one without the other.

Is Don's purchase now a bad thing instead of a positive transaction just because the service provider's name is Jose instead of Joe? Is the United States somehow damaged by this trade? It's really not obvious that any damage is done. Certainly, the direct effects are only positive whether the transaction occurs across borders or completely within the borders of the United States. Everybody involved in this transaction is better off afterwards, and nobody else is worse off.

But there are some secondary effects that aren't necessarily positive and I think they can potentially be noticeable if the investment surplus is large enough. One potentially negative effect is lowered returns to investors in the United States. This can be seen in the very low real interest rates that businesses in the United States (and the government) pay when borrowing money. Since every Tomeo, Dedrick and Hari in the world are falling over each other to invest in and/or lend money to entities in the United States, this drives the cost of money way down for users of capital here. That's fantastic for those needing capital. They can buy and deploy more capital equipment, expand their businesses, hire more people, and sell more product at lower cost. It's also fantastic for keeping unemployment low and for minimizing consumers' expenses.

But investors and lenders (which is anyone with a bank account) within the United States can't get as high a real return on their investments and savings because there is so much foreign competition for those investments. For example, have you checked the interest rate on your checking account lately? Why bother with interest checking anymore?

All of the above effects help the poor and hurt the rich. Lenders are disadvantaged, but business can expand more easily and pay higher salaries to their employees, some of which are low wage earners. Egalitarians should love investment surpluses, no matter how large they are.

Many pundits also lament about the low savings rate in the United States. While I think savings/investment is actually okay, I think that one of the reasons that it isn't higher is because of the large investment surpluses were experiencing. Investment surpluses make dollars valuable. Valuable dollars make foreign products relatively inexpensive and that makes it more enticing to buy such products.

But there's a second reason investment surpluses increase domestic consumption. Let's consider an example. Let's say you have $5,000 in your pocket and you're on the way to the store to buy a large HDTV. On the way, you run into a friend and he wants to borrow that $5,000 for one month. Let's say you have complete confidence that he will pay it back. If he offers to pay you back the $5,000 principal plus $5,000 in interest for one month, I'd bet you'd take the deal. In other words, you would forego current consumption for savings (at least for a month). But instead of $5,000 in interest, let's say he only offered $50 in interest (which would still be a pretty good interest rate). Would you still loan him the money? It would certainly be less likely. I suspect you'd just stick with your original plan and go buy the HDTV.

The effects on returns of the investment surplus obviously aren't as extreme as in the above example, but the point is that the choice between consuming and saving is affected by the rate of return that's expected (adjusted for risk) if the choice is made to save, and the rate of return is affected by the size of the investment surplus. The bigger the investment surplus, the lower the rate of return and the more likely we are to consume instead of save.

This begs the question of why people in other countries are so much more keen to invest here than we are. Many pundits jump to the conclusion that it must be because everybody else is smarter, more disciplined, more future oriented, etc. than stupid, undisciplined, short term oriented, etc. Americans. I can't prove that explanation wrong, but I'd like to put forth a couple of alternate explanations for why it might objectively be a better deal for certain classes of foreigners to invest here than it is for us.

The most obvious explanation is that the dollar is a low risk haven for assets. The United States has a unique combination of stability, prosperity, and opportunity that can't be found anywhere else. For foreigners, this unique combination also represents a diversification. Their main economic potential exists in the country in which they reside because that's where they work. Investing assets in the United States provides a low risk diversification against downturns in their local economic fortunes. Unfortunately, it's asymmetric. If things go poorly in the United States, its citizenry will lose their jobs as they watch their domestic stock and real estate portfolios crash at the same time. But investing outside the United States entails even higher risk. Thus the consumption versus savings calculation is decidedly different for foreigners versus people living in the United States.

The real per capita GDP growth in the United States is quite good for a developed country. Since wages and income correlate with GDP over the long haul, wage growth will also likely be good. What that means is that, on average, we'll all have substantially higher income in the coming decades. If we compare that with countries with low economic growth, we'll have relatively more money to invest in the future than those from other countries. This also objectively tips the balance for us away from savings and investment and towards consumption relative to those in low growth countries.

In summary, a trade deficit is the same thing as an investment surplus, the direct effects from an investment surplus are all positive, some indirect effects are potentially negative, and there are objectively rational explanations for why foreigners are more interested in investing in the United States than we are. Investment surplus sounds oh so much better than trade deficit, and since it's net positive, I prefer using the term investment surplus.

Memetic Warfare

Being rather fond of the benefits of civilization and having an interest in maintaining a free and pluralistic society, I thought this post over at the Armed and Dangerous blog was worthwhile. It is rather remarkable how quickly some people condemn American society for not being perfect while ignoring our history of improvement and the even more flawed alternatives.

Here are some excerpts:

Americans have never really understood ideological warfare. Our gut-level assumption is that everybody in the world really wants the same comfortable material success we have. We use “extremist” as a negative epithetic. Even the few fanatics and revolutionary idealists we have, whatever their political flavor, expect everybody else to behave like a bourgeois.

By contrast, ideological and memetic warfare has been a favored tactic for all of America’s three great adversaries of the last hundred years — Nazis, Communists, and Islamists. All three put substantial effort into cultivating American proxies to influence U.S. domestic policy and foreign policy in favorable directions.

But it was the Soviet Union, in its day, that was the master of this game. They made dezinformatsiya (disinformation) a central weapon of their war against “the main adversary”, the U.S. They conducted memetic subversion against the U.S. on many levels at a scale that is only now becoming clear as historians burrow through their archives and ex-KGB officers sell their memoirs.

In a previous post on Suicidalism, I identified some of the most important of the Soviet Union’s memetic weapons.

As I previously observed, if you trace any of these back far enough, you’ll find a Stalinist intellectual at the bottom.

Indeed, the index of Soviet success is that most of us no longer think of these memes as Communist propaganda. It takes a significant amount of digging and rethinking and remembering, even for a lifelong anti-Communist like myself, to realize that there was a time (within the lifetime of my parents) when all of these ideas would have seemed alien, absurd, and repulsive to most people — at best, the beliefs of a nutty left-wing fringe, and at worst instruments of deliberate subversion intended to destroy the American way of life.

Call it what you will — various other commentators have favored ‘volk-Marxism’ or ‘postmodern leftism’. I’ve called it suicidalism. It was designed to paralyze the West against one enemy, but it’s now being used against us by another. It is no accident that Osama bin Laden so often sounds like he’s reading from back issues of Z magazine, and no accident that both constantly echo the hoariest old cliches of Soviet propaganda in the 1930s and ’40s.

The first step to recovery is understanding the problem. Knowing that suicidalist memes were launched at us as war weapons by the espionage apparatus of the most evil despotism in human history is in itself liberating. Liberating, too, it is to realize that the Noam Chomskys and Michael Moores and Robert Fisks of the world (and their thousands of lesser imitators in faculty lounges everywhere) are not brave transgressive forward-thinkers but pathetic memebots running the program of a dead tyrant.

Again, this is by design. Lenin and Stalin wanted classical-liberal individualism replaced with something less able to resist totalitarianism, not more. Volk-Marxist fantasy and postmodern nihilism served their purposes; the emergence of an adhesive counter-ideology would not have. Thus, the Chomskys and Moores and Fisks are running a program carefully designed to dead-end at nothing.

Religions are good at filling that kind of nothing. Accordingly, if transnational progressivism actually succeeds in smothering liberal individualism, its reward will be to be put to the sword by some flavor of jihadi. Whether the eventual winners are Muslims or Mormons, the future is not going to look like the fuzzy multicultural ecotopia of modern left fantasy. The death of that dream is being written in European banlieus by angry Muslim youths under the light of burning cars.


In the banlieus and elsewhere, Islamist pressure makes it certain that sooner or later the West is going to vomit Stalin’s memes out of its body politic. The worst way would be through a reflex development of Western absolutism — Christian chauvinism, nativism and militarism melding into something like Francoite fascism. The self-panicking leftists who think they see that in today’s Republicans are comically wrong (as witnessed by the fact that they aren’t being systematically jailed and executed), but it is quite a plausible future for the demographically-collapsing nations of Europe.

The author actually offers a somewhat optimistic view of the future. All in all, quite a series of thoughts and observations!

Kudlow Konfused?

Larry Kudlow (of Kudlow & Company fame), in talking about recent news regarding the Iran nuclear threat and the world's response to it, makes the following statement on his blog:

"As for the market’s reaction to all this stuff, you really don’t see it reflected yet in oil prices..."

I find this statement mind boggling coming from an economist like Mr. Kudlow, especially since his commentary is usually so logical and non-controversial (from a mainstream economics perspective). I have no idea why he thinks that this one time the market has chosen to ignore important information (weighted by the probability of those events happening). Especially since it looks to me like the price of oil already has a substantial probability of a significant disruption already priced in. For example, today, according to Reuters:

"U.S. commercial crude supplies shot to the highest level in nearly seven years last week on sluggish refinery use and high imports, the government said on Wednesday. [...]

In May 1999, the last time supplies were as high, oil futures were less than $17 a barrel."

In other words, the natural price level given current supply without the threat of impending disruptions is potentially far below the current price levels (probably not $17, but $35 per barrel is certainly possible). The Iran thing is nothing new and the market had previously incorporated this information in the price.

Pontifications on the Extended Order - Part 2: The Geometry of War and Peace

In Part 1 of this series, I concluded by stating that I was "going to start the narrative regarding the evolution of the extended order based on the belief that the starting point was a bunch of violent primitive tribes frequently at war." Part of the reason I'm developing this series is to write my own creation myth. Since I wasn't there, I obviously don't know that humankind started as "a bunch of violent primitive tribes," rather I simply believe that based on my interpretation of what I've studied combined with my internal view of human nature. Even if you don't believe as I do, I'm hoping for two things. First, that you at least can understand why I've arrived at my conclusion and belief and second, that you have the imaginative capacity to start with my previous conclusion as a premise for this next installment. That would allow us to end with radically different views, while enabling you to follow the logic of my creation myth.

I'm going to introduce the subtopic of geometry that I want to consider with some useless (but somewhat interesting) trivia. Did you know that one of the biggest problems for blue whales is their tendency to overheat, even in frigid arctic waters? As Roger Payne wrote for PBS:

The requirement of being warm blooded would seem to make it impossible for a mammal to reach and harvest krill in polar seas-since those krill are living in an impregnable fortress: ice water, at the ends of the earth, where staying warm while immersed is simply not feasible for a warm-blooded mammal.

Or is it?

Simply by being large an animal like a whale can take advantage of a simple but little-appreciated fact: the fact that the larger an animal's body, the smaller is its surface area in relation to the volume of that body. The reason this is important is that the volume of any animal's body is its furnace-the place where its metabolism generates heat, while the surfaces of its trunk, head, and limbs are its radiators, the things through which heat is lost. Tiny mammals, like mice, have relatively huge surfaces for their small volumes; which means that they have small furnaces and large radiators and therefore have to produce lots of heat to keep from cooling down. But large animals have relatively small surfaces for their large volumes-they have a large furnace and small radiators. That means that their problem is not losing heat but keeping from overheating-particularly when they exercise. Contrary to popular belief, blubber is not principally for keeping warm but for fuel storage.

For a 3 dimensional entity, surface area increases in proportion to the square of the increase in the length of the entity, volume increases with the cube of the length, and the ratio of volume over surface area increases linearly with the length. Considering the whale versus mouse comparison, a blue whale is about 200 times as long as a mouse. Thus, we would predict that a blue whale would weigh 200³ or 8,000,000 times as much as a mouse, have surface area 200² or 40,000 times greater than a mouse, and have a volume to surface area of 200 times as big as a mouse. Given that a mouse weighs about 25 grams and a blue whale weighs about 150 tons, this gives a weight ratio of 5,376,000 to 1 which is pretty close to our prediction of 8,000,000 to 1. I'll bet you never knew that it takes over 5 million mice to balance one blue whale. There are only around 2,000 blue whales left on the planet, but those 2,000 whales have the equivalent weight and volume of over 10 billion mice. 2,000 whales are potentially endangered, while 10 billion mice are not.

The same sort of principle applies to large office space. For example, prior to its demise, the World Trade Center in New York was so large and therefore had such a high volume to surface area ratio, that it required the world's largest refrigeration plant, "with 60,000 tons of cooling capacity," to keep it cool, and the refrigeration capacity was utilized throughout the brutal New York winter (even worse than Afghanistan winters, turns out). Every light bulb, every person, every computer, every robot (well, not many robots) generated heat, and the exterior surface area wasn't enough to dissipate all that heat without help from the cooling plant.

Just as a 3 dimensional entity's surface encloses even more volume as it gets bigger, a 2 dimensional entity's perimeter encloses an even larger area as it expands. The formula here is that the area increases in proportion to the square of the increase in the perimeter. Also, the exact shape doesn't matter. The relationship holds for any convex shape.

At a given level of technology, there are a maximum number of people that can survive in a given isolated area. That population density, especially for a primitive people, is basically limited by the quantity of food that can be gathered and/or grown. Also for a primitive people (and maybe not so primitive), the population tends to expand to take advantage of the available food supply. The bigger the area, the greater the amount of available food, and therefore the greater the number of people. In other words, the number of people that can be supported is proportional to the area they live in.

A tribe has to be able to defend the area that they live in from other tribes that would like to slaughter them and take over their food supply. The defense happens at the (fairly fluid) border between the two tribes, along the perimeter. Assume each tribe is surrounded by other tribes. Then each tribe has to defend its entire perimeter. I realize that this is hugely oversimplified and ignores all sorts of military tactics and assumes a pre-aviation world, but I think the basic idea holds.

As an example, consider the very friendly and hypothetical Tuber Tribe (so named because the only somewhat anthropomorphic image I could find laying around on my computer is the potato person in the figure below).

Each tuber Tom requires one square of area of land to support himself. A Tuber Tribe of four requires four squares.

But the Tuber Tribe also needs to defend itself. In order to keep their area and the associated resources (i.e. food), the eight positions marked by bombs have to be defended from attacks by the surrounding tribes. In this case, only four tuber Toms have to defend eight positions.

A second Tuber Tribe has 16 members with the corresponding increase in area. It has four times as many members, but the perimeter only doubled. The 16 tuber Toms need to defend 16 perimeter positions. This is a one-to-one ratio instead of the inferior one-to-two ratio shown above.

In a nation of 1,000,000 tubers, there would be only 4,000 perimeter positions to defend. In this case 99.6% of the tuber Toms would not be needed for defense and could be employed doing something else.

In small primitive tribes, one of the things that is particularly brutal, is that every adult (male) needs to be involved in every war directly on the front, whereas even in the brutal wars of the 20th century, a far, far smaller percentage of the populations of the world actually fought.

So there is a major advantage for tribes to become as large as possible, in other words, to combine tribes in order to become nations. This is obviously true if a single large nation forms while all the rest of the people remain part of small tribes. The single nation is then clearly invincible and can also attack and conquer the small tribes with impunity.

However, it's also true that even as organizational methods spread such that many nations evolved from tribes, the size advantage was beneficial to all. All groups of humanity could still be at war, but a far lower percentage of each group needed to be involved in the actual fighting.

In summary, my conclusion is that because humankind engages in war by nature, genetic and/or memetic enhancements that enabled larger and longer lasting societies occupying larger areas were hugely advantageous for the warring groups, even if all of the groups were the same size.

In the next several parts of this series I'll look at some of the changes that enabled humans to organize into ever larger groups in order to capture the geometric area to perimeter advantage.

Limerick War

The most amazing set of limericks that I've ever seen (and perhaps that have ever been written) can be found in the comments to this post over at the Daily Duck. The most impressive ones begin about half way down (Feb 21, 10:08 AM) where the various commentators begin debating about religion and the Danish cartoons in verse.

Amazing!

A Bet, Price Discovery, and the Peak Oil Predicament

Update 3/5/06: Added some verbage to make a couple of points clearer...

There's seems to be an ever increasing number of perplexed pundits pontificating about the purported peak oil predicament. For example, Russ Roberts at Cafe Hayek links to the following New York Times article excerpt:

[T]here will come a day when oil production "peaks," when demand overtakes supply (and never looks back), resulting in large and possibly catastrophic price increases that could make today's $60-a-barrel oil look like chump change.

In this post I will show why I think the peak oil problem isn't a crisis (or anything like a crisis), won't lead (by itself) to large and “catastrophic price increases” and doesn't warrant a lot of government intervention (which is the conclusion of the NY Times article). To do so, I will begin by describing an amusing bet by a couple of the Daily Duckie dudes, and use that scenario to illustrate the concept of price discovery mechanisms. Those mechanisms will lay the foundation for us to examine the concept of a cost-of-carry market, which will in turn be used to argue against any rapid and "catastrophic" changes in the price of oil due to the peak oil concept that has so many people so worried. I'm going to keep this all as non-technical as possible, but being a commodities future trader (though currently inactive), concepts that I consider to be obvious may not be, so ask questions in the comments and I'll be more than happy to answer them.

The bet is between Duck and Oroborous. Duck bets that oil will hit $100 per barrel by the end of this year (2006). For Duck's sake, I hope the bet is small, because he's not only betting against Oroborous, but he's also betting way, way against all of the money in the crude futures markets, and that is generally a very, very bad idea.

First, a few definitions are needed. In the world of commodities, the “spot market” refers to buying or selling (or at least pricing) the specific commodity right now. Entities that use the spot market are actual producers and consumers of the commodity.

A futures market is a market that enables buying and selling (and pricing) a commodity at a specific date in the future. For example, you can enter into a contract to buy or sell 1,000 barrels of Light Sweet Crude in July, 2006 via the New York Mercantile Exchange (NYMEX). Entities that utilize the futures markets include the producers and consumers of the commodity (known as hedgers), speculators, and arbitragers.

The hedger's goal is to lock in a price for the commodity that they want to buy or sell in the future. For example, if you're a corn farmer, it's important that you know you can sell the corn that you're about to plant for a profitable price after you harvest it. So you enter (sell) a contract before planting to deliver your corn after harvest at a profitable price. If the futures price is too low (i.e. doesn't enable you to make a profit), you don't bother planting and you don't sell the contract. If the price is adequately profitable, the futures contract enables you to get a loan from the bank to buy the seeds and other necessary equipment. So for the hedger, the futures market provides an insurance function.

The speculators provide that insurance. They do so by providing the liquidity that drives the market to the point that best balances the expected needs of buyers and sellers for that market on the delivery date (also called the expiration date). If the market were perfect with perfect predictive powers (e.g. godlike), the price of the futures contract would be driven by the speculators (and arbitragers) to what the spot market price of the commodity will be on the day the contract expires. The spot market price is the price that best balances the needs of buyers and sellers for that market at that given instant in time.

For example, let's say that in July, 2006 the spot price for oil ends up being $60.00 a barrel. If the market were perfect with perfect ability to predict the future, then the current price (and yesterday's price and tomorrow's price, etc.) of the July 2006 futures contract for oil would also be $60.00 barrel. But, market's cannot perfectly predict the future. They can only predict the future based on currently available (and historical) information. As new information regarding supply and demand becomes available, the price fluctuates, though it eventually converges on the the spot price as the contract nears the delivery date.

The speculators have a powerful incentive to be right. If a futures contract price is below what the spot market price will be when it's time for that contract's delivery, and the speculator buys that futures contract, he'll make a lot of money. If he sells, he'll lose a lot of money. Speculators that are able to analyze the data and consistently make the right decisions make a lot of money. Speculators who can't consistently make the right decisions lose money and generally drop out of the game pretty quickly. Thus, the speculators, on aggregate, tend to drive the price toward an optimal price point. This is what's known as the futures market price discovery mechanism. The market finds the best possible prediction of the price of that commodity for the specified future date. Note that this price discovery mechanism, via the speculators, takes all information about all current and future events (including an estimation of the probability of those events) into account. This includes information about the likelihood of war in Iran, unrest in Saudi Arabia, depletion of oil fields in Kuwait, etc.

Now back to Duck's bet. The futures prices for all of the remaining contracts for this year show a price between $60 and $70 per barrel. That means that the people who are willing to put big money on the line, in aggregate, expect oil to remain in that range for the rest of the year. Again, it's people putting big money on the line, who in aggregate, have taken all known information into account. And Duck has bet against them - to the tune of $35 dollars per barrel.

Well, not quite. Duck still has one small thing in his favor: volatility. In other words, even though the predicted price of oil for all months is less than $70, there is some probability that short term swings will happen to push the spot price of crude oil over $100 for at least one trade (in the spot market), in which case Duck wins the bet. It turns out we can roughly estimate that probability fairly easily.

First we assume that the distribution of price changes is a normal distribution. It turns out that the distribution of price changes is not quite normal, but it's close enough for a rough estimate. Next, we look at the monthly price changes for crude oil (in the spot market) and see that the standard deviation of those price changes is approximately $10. Next we know that the standard deviation for price movements over a different time frame for a normal distribution is the square root of the ratio of the time frames times the original standard deviation. There's roughly ten months left in the bet, so we can estimate the standard deviation over the time remaining in the bet to be the square root of 10 times $10, or approximately $32. That means that $100 per barrel of oil is a bit more than one standard deviation higher in price than all of the current futures prices for all of the months remaining in the bet. Using standard normal distribution statistical tables, we can conclude that Duck has an approximately 85 percent chance of losing the bet at this point (or a 15 percent chance of winning). This is still not quite accurate, since the above analysis includes only those possibilities that end over $100 per barrel and not those that go over $100 and then end below $100 per barrel at the end of the year, but it's good enough for a rough estimate in this case.

Let's check our calculations by looking at the price of call options on $100 oil for the remaining futures contracts. The price of the calls for each of the remaining months is only pennies, so our estimate of Duck having a 15 percent chance of winning is generous (and my guess is that I've overestimated the monthly standard deviation, which I did by eye, not spreadsheet). If the bet between them is big enough (which I somehow doubt), Oroborous could actually lock in profit by buying a call for each of the contracts between now and January 2007. There's no way for Duck to lock in profit.

But it's not over until the fat lady takes an oil bath (not a pretty sight), so Duck still has a chance.

We now need to explore an important constraint on the difference in the price between any two points in time for a given (non-perishable) commodity.

Let's say that due to expected changes in supply and demand that next month you expect crude oil to be $80 per barrel. Since you can currently by a barrel of oil for less than $70, it would make sense to buy oil and store it and then sell it next month for a profit. Indeed, as long as the spot price is far enough below the price you expect next month, you would keep buying and storing all the oil you could. How much is far enough below? This question introduces the cost-of-carry model of an asset:

F = S + C – R

where F is the price of the commodity in the future, S is the spot price, C is the cost of carrying the asset for the time you're going to hold the asset, and R is any return you might get on the asset while you're holding it (which is zero for crude oil but non-zero for some financial instruments). The cost of carrying the asset includes storage and financing costs.

What's important here is that people will continue to buy in the spot market as long as F > S + C – R, because it's basically free money. This isn't even a speculation, rather it's a type of arbitrage. This drives the spot price up and alleviates current gluts and potential future shortages while reducing overall volatility.

You actually see carry cost markets in real life when there is a glut of the commodity (at least relative to the expected future supply). When this happens, the commodity generally has a much lower than average price and relatively low volatility. Each futures contract is priced over the previous contract by nearly exactly the amount it costs to carry the commodity for the length of time between the two contract expiration dates.

The important point is that the expected future price of a commodity can never be very much above the current spot market price plus the carrying cost for that commodity. If it is, people will buy in the spot market and store the commodity. Because of this, the current spot market price already takes into account expected future shortages, if any.

Because there is the upper bound on the price of oil in the future relative to the current price, it is unlikely that at some arbitrary point in the future huge spikes in the price of oil will occur simply because of long term expected changes in supply and demand. There are many things that can cause large changes in price (e.g. middle east wars, though even this sort of thing is already reflected in the spot and future prices), but the peak oil model of dwindling supplies is not one of them. The peak oil concept will not bring civilization as we know it crashing down. The F = S + C – R relationship guarantees that the sort of supply/demand price dislocation predicted by the peak oil alarmists will be relatively steady and smooth, giving the world economy many years, or even decades, to adapt.

Crude oil futures trade quite far out. The latest available contract is for delivery in December of 2012. That's almost seven years from now. Yesterday's settle price for that contract was $65.10. Yesterday's spot price was about $63. The big money says that in seven years the price of crude is going to be more or less the same as it is now.

Don't believe it? Think that the peak oil model will make the price far higher by then? Then do a type of trade called a spread: buy the December 2012 contract and sell a nearer term contract. Short term price fluctuations cancel each other out since you'd be on both sides of the market and you'll profit handsomely on the spread if you're right about the effects of the peak oil model. Your action would cause the December 2012 contract to rise relative to the near term contracts, and if you're right, you would be adding good information to the market and benefiting everybody. Indeed, the cost-of-carry model limit for December 2012 is probably somewhere around $100 per barrel. If $100 was the price for that contract, I'd take the peak oil alarmists much more seriously (though I'd bet we could easily adapt to $100 per barrel oil over the course of 7 years since it's only about a $5 per year increase in price). But right now, clearly, the peak oil alarmists are hugely outnumbered in the market by money that says they're wrong, making it difficult for me to give their opinion much weight.

Technological innovation is accelerating. Seven years is a long time. And even after that, our favorite equation (F = S + C – R) guarantees slow long term increases in price (short term volatility can still be huge, but has nothing to do with the peak oil model).

Thus I conclude that the peak oil model is not a good reason for governments to get involved in energy technology development at the current time.

Fly the Over-Lawyered Skies

I was on an airplane yesterday from Manchester, New Hampshire to Chicago and it was quite bumpy the whole way. The captain left the seat belt on the entire time. The plane was packed and most of the patrons drank a can of soda or something similar. Here's a bit of a conversation I overheard after a couple hours in the air:

Passenger: I know the seat belt sign is on, but can I use the lavatory?

Flight Attendant: Federal law prohibits that I answer your question with yes, though the cabin crew will not physically try to stop you. However, I must warn you that if you get up out of your seat you will put yourself and the other passengers in grave danger.

I'm not sure, but I'm thinkin' that the flight attendant's response was not spontaneous and was carefully crafted by United's lawyers and carefully rehearsed by their flight attendants. I'm also wondering just how "grave" the danger could be given that the cabin crew was wandering around collecting trash.

Nonetheless, the passenger chose to remain in his seat.